exam #3 notes

# exam #3 notes - The Cost of Capital 1 Dividend payout ratio...

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The Cost of Capital 1. Dividend payout ratio: dividends/ NI 2. Capital Component: one of the types of capital used by firms to raise funds. 3. Target (Optimal) Capital Structure: percentage of debt, preferred stock, and common equity that will maximize the firm’s stock price. 4. Weighted Average Cost of Capital (WACC): weighted average of the component costs of debt, preferred stock, and common equity. a. WACC = w d r d (1-T) + w p r p + w c r s i. w d % of DEBT ii. r d (1-T) after tax cost of DEBT - Relevant cost of new debt, taking into account the tax deductibility of interest; used to calculate WACC. iii. r d = I = YTM marginal cost of debt capital (aka yield to maturity on outstanding LT debt) iv. w p % of preferred stock - Rate of return investors require on the firm’s preferred stock. R p is the preferred stock divided by the current price v. r p cost of preferred stock vi. w c % of common equity vii. r s cost of common equity - Rate of return required by stockholders on a firm’s common stock. viii. r e rate of return investors require on the firm’s common equity

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- Cost of external equity; based on the cost of retained earnings, but increased for flotation costs. ix. W’s refer to the firm’s capital structure weights x. r’s refer to the cost of each component b. Accept projects whose rate of return is greater than WACC. c. Stockholders focus on after-tax capital costs. 5. Cost of Preferred Stock a. V p = r p = D 0 / P p (preferred stock dividend/ current price) 6. Determine the cost of common equity (r s ) a. CAPM: r s = r RF + (r M – r RF )b i. Market risk premium = r M - r RF b. Discounted Cash Flow (DCF): r s = (D 1 / P 0 ) + g = [D 0 (1+g)] / P 0 + g c. Own-bond-yield-plus-risk-premium: r s = r d + RP i. Midpoint of the risk premium range = 4% (3% to 5%) ii. RP is not the same as CAPM RP M iii. This method provides ballpark estimate of r e 7. Determine the rate of return required by investors (r e ) a. r e = [D 0 (1+g)] / [P 0 (1 – F)] +g i. F is the flotation cost b. Flotation Costs: percentage cost of issuing new common stock. i. Flotation costs depend on the firm’s risk and the type of capital being raised. c. Retained Earnings Breakpoint: amount of capital raised beyond which new common stock must be issued.
i. Retained earnings breakpoint = additional RE / equity fraction Chapter 11: The Basics of Capital Budgeting 1. Capital Budgeting a. Capital budgeting: process of planning expenditure on assets whose cash flows are expected to extend beyond one year.

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exam #3 notes - The Cost of Capital 1 Dividend payout ratio...

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